Early United States History and the Great Depression

This is the third post in a series entitled Currency, Money and the Economy.

From its early days of independence until 1913, the United States was only a loose knit republic of states (historical playbook, step 1). We were not a global power, as England, France, Spain, and Portugal continued their colonial conquests. We had our share of wars, booms and busts, but were still surviving. However, a banking scandal now known as the Panic of 1907 led to the eventual passing of the Federal Reserve Act in 1913. Up until then, Congress had had the right to coin money, and usually outsourced the job to many banks. However, Congress gave up that right when it created the Federal Reserve Bank. Most people think the Federal Reserve is a government agency. However, it is really a private bank that has the power to create currency from nothing and is shielded from audits and congressional oversights. Coincidentally, that same year the income tax was introduced. For the first time in the United States, the loose knit republic was becoming centralized and power was being consolidated at the national level.

World War I would change the role of the United States forever (historical playbook, step 2). While the United States stayed out of the fighting early on, most of Europe’s economy became engaged in producing goods for the war effort. Thus, in order to still supply its citizens with daily necessities, they imported what they needed from the United States. Since every power still had currency backed by gold, that meant the United States saw an influx of gold during World War I. At the end of World War I, the United States had a huge supply of gold reserves. Based on the amount of gold it had on hand, banks could loan an amount to the general public at a certain ratio (known as the reserve ratio). Thus, with a ton of gold that the United States had, the amount of money loaned out was also tremendous. And the people spent it, much like they did today, in what is now known as the Roaring Twenties. Eventually, most of the money found its way into the stock market and the real estate market. Well, with every bubble comes the crash, and in 1929, the house of cards fell apart to begin the Great Depression.

The main component of the Great Depression was deflation. How was this achieved? Let’s take a look at the banks again. When someone deposits currency into the bank, the bank can take a ratio of the deposit (say 10 times the deposit amount) and loan it out. However, when someone withdraws its currency from the bank, the bank must remove that same ratio amount from the currency in circulation. When people panicked after the stock market crash, they made a beeline for the bank to withdraw their currency. As a result, banks were forced to call in tons of loans they had on their books. The holders of those loans could not pay them off in their current economic state, so they simply defaulted on them. By loans going bad or banks taking them off the books, the currency supply shrank at a tremendous pace. Many banks went of business simply because they could not balance the reserve ratio anymore. The only thing that did not fall in value was gold and silver.

It was during this period that President Roosevelt consolidated the power of the federal government. Since states were in shambles and broke, they gladly deferred power for federal assistance. And thus any remainders of the loose knit republic our founding fathers designed were swept away as the American Empire took its place.

Across the Atlantic Ocean, Europe was having very different problem. Because most of their gold went overseas to the United States, many nations had to rebuild their economies by printing currency, lots and lots of it. Thus, while the United States was suffering from depression, Europe was battling inflation. Inflation in the Weimar Republic of Germany was so bad that it eventually led to the rise of Adolf Hitler to political power, leading the world into World War II.

In the next post, we will continue our history lesson.