In 1848, gold was discovered in California. Soon men (almost no women) from all over the world were on their way to California (see Holiday 1999). Initially, the methods used to take the gold were simple. The gold was found initially in riverbeds. The gravel was scooped up and washed in a pan; the heavier gold remained, and the lighter elements washed away. If no gold was found, it was said that the gravel didn’t “pan out.” The miners, however, soon began to build machines that could wash larger and larger amounts of gravel. They realized, moreover, that still larger deposits must lie in the mountains crossed by the streams they worked. Where, they asked, was the “mother lode”? Soon the source of gold was found, and conventional mining began.
Because gold was the basis of much of the world’s monetary system, the outpouring of gold from California (and from Australia, where discoveries were soon made) increased the world’s money supplies. Table 12.1 shows the results in the United States. An index of the stock of money in the United States rose from 100 in 1849 to a peak of 182 in 1856, a rate of increase of about 8.5 percent per year. The result was a long economic boom, as indicated by the increase in gross domestic product (GDP) shown in column 3 of Table 12.1, and a substantial increase in prices, as shown in column 4.
How do we know that the increase in the stock of money, not some other factor, caused the inflation? We cannot know for sure: Correlation does not prove causation. In this case, however, we have a “natural experiment.” We know that the increase in the stock of money was mostly due to luck. Either the inflation that followed occurred by chance, or it was caused by the increase in the stock of money; the inflation could not have caused the increase in the amount of gold. Recall Economic Reasoning Proposition 5, evidence and theory give value to opinions.
All prices did not rise at the same rate during the inflation. An example is shown in the last two columns of Table 12.1. Farm prices rose sooner and further than the prices of chemicals and drugs. By 1855, farm prices had risen 58 percent compared to 17 percent for chemical and drug prices; chemical and drug prices had fallen 41 percent relative to farm prices. Why were there such disparities? Factors specific to individual markets are likely to affect relative prices: Good or bad harvests, technological progress, changes in consumer tastes, and so on, must be brought into the story when we discuss relative prices. The monetary expansion also may have played a role. It may have been true, as the great British economist William Stanley Jevons suggested, that prices in more competitive markets, such as agriculture, responded faster to the monetary expansion.
The long expansion came to an end in the Crisis of 1857, which is clearly visible in Table 12.1 as a sudden decline in money and (a year later) in prices. The failure of the Ohio Life Insurance and Trust Company, a large bank with a reputation for sound investing that had invested heavily in western railroad bonds, shocked the financial community. Distrust of banks spread. Soon there were runs, and the banks, desperate to protect themselves, called in loans and refused to make new ones. The result was a sharp recession. Unemployment rose, and New York experienced bread riots. The crisis, moreover, aggravated the tensions that were already pulling the country apart. In the North, the newly formed Republican Party argued that the crisis showed that traditional parties did not know how to manage the economy. In the South, advocates of secession argued that the relatively mild impact of the crisis on the South proved that cotton was king and that the South would be better off without the North.